There are a lot of companies who are in the business of managing an individual’s mutual fund portfolio. These companies normally charge a nominal fee, maybe 1% of assets each year or charge by the number of transactions they perform each year. For people who want to have nothing to do with their investments, this may be a good approach. Even then, however, you should check the performance of your manager against some benchmarks like the S&P500. This should only be done after a number of years – say five years – ideally in a period that includes both up and down years, since the record over a few years does not mean anything.
For those who are willing to spend a little bit of time, however, those management fees can be saved. While the fees may seem small, over long periods of time the savings can add up to a lot of money if the funds are reinvested and allowed to compound.
Here are some of the secrets of mutual fund investing that the management companies use:
1. Diversification is key.
Most managers will try to diversify your investments, meaning that they invest in a lot of different types of things. The reason is that different investments do better during different periods of time. Sometimes small stocks do great while large stocks lag the market. Other times bonds and stocks with high yields may do well compared to growth stocks (usually periods where the market declines). Beyond US stocks, owning stock in foreign companies can be advantageous since other countries may be in a boom time while the US is lagging (note that owning large companies that sell products around the world also provides some protection from declines in one country’s economy). Adding real estate through REITs or REIT funds can also help. In determining how to allocate funds, spreading your money among asset types is wise. For example, 20% each in small stocks, large stocks, international stocks, an REIT, and a bond fund would be better than putting 100% in a small cap fund.
2. You should have target allocations based on your investment time and risk tolerance.
The shorter a period of time until you need the money, the less volatility you can tolerate. Also, the more you worry about movements in your portfolio value, the less risk you can take. Taking more risk over longer periods of time will result in higher returns, but the shorter the period of time the greater your chances of a loss. A rule of thumb was to have your age in bonds and other income-paying assets and the rest in stocks. For example, a 20-year old would be 20% in bonds. With people living and retiring later, this might be too conservative. Then again, a 20-year old who worries when the market moves down 10% might want to be 50% in bonds and dividend paying stocks.
3. You reduce volatility (without necessarily reducing returns) by adding more income funds and having assets that are not correlated.
Assets that pay a large dividend or rate of interest generally change in price less than those that do not. In addition, a dividend can provide income even when the price of assets are stagnant. Both of these factors reduce the level of volatility. Volatility is nice during big spikes in the market but can be gut wrenching during declines. Having assets that aren’t correlated, meaning that they do not tend to go up or down in price at the same time, also reduces volatility. For example, stocks and real estate. There are times, however, such as the 2008 crash where everything gets impacted.
4. Don’t change investments too often.
From the commercials, you would think that the manager at the investment firm is watching the prices of funds all day long, darting and out to maximize profits. In actuality you want to trade very rarely. You never know when a sector of the market will make a big move up, so you don’t want to sell out of a fund. If you miss these big moves your returns will suffer greatly. The most you should do is rebalance your funds about once a year, selling those that have done really well and buying more of those that have done less well to reset the percentage you have allocated to each fund to your target distributions. Trading more than that is a waste of time, increases costs for everyone in the fund, and may result in lagging returns.
5. Managing your money in mutual funds isn’t that hard.
By their nature, mutual funds reduce risk by spreading out your money into a lot of different assets. Because they buy so many assets, their return will basically track the market, minus fees. This means that a fund that invests in large caps will basically track the return of the S&P500. One that invests in utilities will track the Dow Jones Utility index. Choosing afund is really little more than finding the one that invests in the types of assets you wish and that has low fees. While there are some managers who are hot for a while, this rarely ever lasts. over time the low cost fnd will generally win out.
6. Verify your diversification.
This is one of the main reasons to use an investment firm to buy funds – they may have tools to quickly determine how diversified you really are with a given set of funds. Two funds may sound totally different from their name but actually hold many of the same companies. One of the best ways to ensure diversity is to buy index funds rather than managed funds. For example, buy an S&P500 index fund for large caps and a Russell 2000 fund for small caps. You can also see what is in the funds from the prospectus, but this requires some time and the assets may change over time as the manager sells one thing and buys another.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.